If you own a family business, it’s likely you’ve considered gifting or selling stock to your children.
But before you do, you should consider the tax implications.
If you sell to your children, they’ll owe taxes. But if you gift the stock, the next generation won’t face a tax burden. Another option is to transfer ownership upon death tax-free and take a step-up in basis in the stock.
When weighing these options — and others — it can be difficult to figure out which is the right option for you.
Here are four key considerations that can help you decide whether gifting is the right option:
1. Keep the growth of the company out of your estate
If your estate is getting close to taxable estate limits, keeping the growth out of the company is a good tax planning strategy to reduce estate taxes. Any growth in the company value after the date of the gift stays out of your estate and may eliminate future estate tax.
For example, if you gift your company to your child in 2020 when it is worth $5 million and it grows to $15 million at the time of your death, all of the growth is out of your estate. Even though the company value grew to $15 million above the lifetime gift exemption of $11.58 million there is no taxable value included in your estate. You only use $5 million of your lifetime exemption. At the time of the gift, a gift tax return would be filed with the appropriate value determined by a qualified appraiser.
2. Take advantage of annual gift tax exemption $15,000 per person
You can give up to $15,000 per year in 2020 to one or more people (the annual gift exemption adjusts each year for inflation). If you are married both you and your spouse can give the annual amount for a combined amount of $30,000 per individual this year. Annual gifts that qualify under this exclusion do not reduce the lifetime estate or gift tax exemptions.
Parents with four children could transfer to the children interest in the business that total $120,000 ($30,000 X 4) this year without reducing the lifetime exemption. With discounting discussed below, the $120,000 represents a much larger value to the children. For example, at a 30 percent discount rate, the $120,000 will really represent $185,714 rounded ($130,000/70%).
You could consider a systematic gifting approach where you gift the annual exemption amount each year. The disadvantage to this approach is you still have the growth of the business in your estate for the percentage you own.
If your company value is small this may be a good approach to consider.
3. Use lifetime exemption before it is reduced in 2026
Under the current tax laws, the lifetime exemption is set to decrease in 2026. If your estate is anticipated to be greater than the current lifetime exemption, you may want to consider maxing out your gifts to the current limit. After it does down, it may not ever go back to that amount and you will have to pay tax in your estate on something you could have removed tax free.
When you gift an interest in your company you will not have to pay taxes on the gift until the total value of the gift(s) is over $11.58 million in 2020. If you are married you can gift up to $23.16 million before you would have to pay taxes, if no other gifts have been made. The lifetime exemption adjusts annually for inflation. You won’t be subject to capital gain taxes or estate taxes after the transfer is complete as you will no longer own that portion of the company.
The lifetime exemption is slated to revert to pre-reform levels in 2026 if no changes are made. Now is the time to act so that you can take advantage of the higher limit.
4. Get the discount for lack of marketability and lack of control
When a privately held company is sold or gifted, the value of the company may be reduced by the lack of control and lack of marketability discounts. These discounts are due to the inability of a minority shareholder to sell their stock and the lower price someone would pay for that stock if they don’t have control of the business. With these discounts, a parent can transfer more stock under the gifting limits and get more of their assets out of their estate. It is better to transfer a minority interest in a company than to transfer undiscounted cash.
Discounts for lack of control and marketability are dependent on many variables but can range from 10% to 25% each.
Take advantage of the discount for lack of control and discount for lack of marketability and the annual donee exclusion with spouse to save sizable estate and gift taxes.
Be aware that Congress and future presidents could limit the discounting strategy so it’s best to take advantage of them while you can. Previously, Congress had included a proposal to disregard discounts for restrictions that will lapse or may be removed by the transferor or family. The proposed IRC 2704 regulation that would have limited discounting options was stopped with the change from U.S. presidents. There is uncertainty to the discounting options and the idea of limiting discounting could arise again with changes in leadership.
How Wipfli can help
In order to have a successful transition of your business you need to plan. And our team can help you with that plan.
For help with tax considerations or any other aspect of gifting your business, contact us. For additional information, see our web page on transition planning or check out these resources: